Traditional Pension Funds: Healthy but Dying?

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Sometimes dying branches must be culled for the good of the tree. America’s traditional corporate pension funds have showed renewed vitality this year, offering steady returns and fewer liabilities. But their current well-being may stem in part from the shakeout of liabilities from the most volatile plans.

In 2006 corporate pension funds rode the wave of surging stock-market returns and higher interest rates to nearly reach full funding for the first time this decade, according to a recent study by Milliman, an actuarial consultancy. The survey of 100 companies that comprise 75 percent of the private sector’s traditional pension money showed that the assets of the plans came close to matching liabilities. Fund performance also beat expectations, gaining returns of 12.8 percent rather than the forecasted 8.4 percent.

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The low expectations were not unwarranted. The decision of the Financial Accounting Standards Board last year to insist that companies record the funded status of their pension plans on their financial balance sheets struck fear in corporations. Volatile defined-benefit plans might shrink the net worth of some companies and send share prices tumbling, some worried.

Such anxieties may have led some companies to freeze their plans. “The overall trend is for companies to move away from these plans,” says James Klein, president of the American Benefits Council. “These are long-term obligations that are sensitive to modest moves in the stock market.”

Over the past year, big companies continued to phase out traditional pension plans. In 2006, General Motors switched salaried employees hired after January 1, 2001 to 401(k) plans, saving the automaker $420 million in 2007. Citigroup, the world’s biggest bank, is freezing benefit accruals in its $10 billion cash-balance plan and switching employees into a $12 billion 401(k), with a higher match. And Fidelity Investments, the Boston-based money manager, will unplug its $727 million defined-benefit plan in May, and move its 32,000 employees to its 401(k).

The number of defined-benefit pension plans overall has been cut in half between 1995 and 2005, shrinking from 58,000 to just 29,000, according to Klein. Companies have begun to favor cash-balance plans—defined-benefit plans that maintain account balances but still let employers shoulder the risk—and 401(k)s.

Indeed, 84 percent of U.S. employees are enrolled in 401(k)s or other defined-compensation schemes. What’s more, last year’s Pension Protection Act has made it easier for employers to automatically enroll employees in such plans and give employers the ability and incentive to rebalance plan investments with less of a legal burden.

The shift to defined-contribution and cash-balance plans pension plans as part of the retiree-benefit mix is apparently enabling companies to offer better-funded, less liable traditional pensions with lower payouts. After averaging more than $48 billion in the previous three years, employer contributions to defined-benefit plans shrunk to $35.7 billion in 2006, according to the Milliman study. John Ehrhardt, an actuary with the consulting firm, predicts that the number will decline to $30 billion in 2007 and then spike to $50 billion in 2008 as the PPA’s new funding rules and faster funding timeframes are established in the latter year.

To be sure, a plan’s funded status doesn’t give a full picture of a plan’s health, since the volatility of its assets and liabilities—gauged by the movements of the financial markets and interest rates—also must be taken into account. “A plan’s funding can improve, even when contributions to the plan decline, and vice versa,” says Klein.

At the same time, some wonder if the appearance of better pension funds could curb the demise of defined-benefit plans. “I think the decline will slow down to a trickle,” says Ehrhardt, arguing that better funding and new investment strategy solutions could dampen volatility.

Despite the drop in defined-benefit plans, they still serve a substantial number of employees and retirees. In fact, 41 percent of workers say that they or their spouse have one, while 62 percent claim that they expect to receive income from such a plan, according to a survey just published by the Employee Benefit Research Institute.

Further, advocates for defined-benefit plans still say the plans can still serve certain well-targeted employer goals. The struggle for talent could allow traditional plans to hang on longer if companies find themselves in need of mid-career employees with skills and experience, consultants contend. “If everyone is getting rid of defined-benefit plans, maybe there’s a competitive advantage there,” says Joel Rich, a senior vice president with Sibson Consulting.